'Is it really worth avoiding environmentally irresponsible or unethical companies, if those shares will ultimately be owned by someone else anyway?'

This question, received earlier this month from a webinar attendee, is one that I hear some version of on a regular basis.

 

I'll get to whether avoiding an irresponsible company makes a difference, but first keep in mind that even though the terms "responsible" and "sustainable" investing are often used interchangeably today, the use of “irresponsible" here obscures the main thrust of what I prefer to call "sustainable investing."

Virtually all sustainable funds today are focused on integrating the consideration of environmental, social, and corporate governance issues in the investment process rather than just flatly avoiding so-called irresponsible companies.

The role of ESG varies by fund. Some may consider ESG only in extreme cases and even then may not avoid a company with ESG-related problems if its stock is priced right. For others, ESG analysis is more central to every security-selection and portfolio-construction decision.

The idea is to populate a portfolio with companies that perform well on the financially material ESG-related issues that affect their businesses and avoid those that are not addressing these issues effectively. For a transportation company - an airline, for example - the biggest ESG concerns may be carbon emissions, safety, and human capital.

For a social-media company, material ESG issues include data privacy and security, content governance, and anticompetitive practices.

All other things equal, an ESG manager prefers the ESG leaders over the laggards. In so doing, the portfolio has less exposure to ESG-related risks.

Companies that address ESG risks most effectively also tend to be high-quality companies.

My view is that strong ESG performance is becoming a hallmark of what it means to be a quality company in the 21st century. Quality companies tend to turn their competitive advantages into steady long-term growth.

The point of ESG analysis is not to identify "responsible" and "irresponsible" companies. The point is to identify companies that are more effectively addressing the significant ESG issues they face today.

It is not so much about using ESG to reflect an investor's values in a portfolio as it is about using ESG to enhance the financial value of the portfolio.

All that said, the question does have relevance when it comes to excluding a company from a portfolio based on its primary activities: a tobacco company, for example, or one heavily exposed to fossil fuels.

Many, but not all, sustainable funds also employ some exclusions.

Does avoidance make a difference? Wouldn't another investor come along to take the place of the "responsible" investor? And if enough investors shun a company's stock, it could become undervalued and end up outperforming for those who don't have any problem investing in it.

There are three ways that avoidance can make a difference:

  1. By sending a broader message about the harmful effects of a company or its products, avoidance can help drive change. Companies are more concerned than ever before about their reputations, so negative headlines can affect their behaviour.
  2. Avoidance may reflect a financially driven investment view. Avoiding companies exposed to fossil fuel, for example, may not reflect a judgement that oil and gas companies are "irresponsible" because fossil fuels cause global warming. Instead, avoidance may reflect the investment view that fossil-fuel reserves are destined to become stranded assets as the world transitions to low-carbon energy, and those companies whose business is fossil-fuel extraction will underperform and eventually go out of business unless they undergo major restructuring.
  3. From a behavioural finance perspective, like any other product/service that I buy, in addition to the utilitarian benefit I get from an investment (an increase in wealth), I receive emotional (how does it make me feel?) and expressive (does it reflect who I am?) benefits. If I think that investing in guns or tobacco or private prisons is immoral, then I want them out of my portfolio because my emotional and expressive payouts are negative. It's just not worth it to me. I can make money from my investments in other ways.

Moreover, because of the advanced optimisation techniques available today, it's possible to substitute for exclusions in a portfolio so that tracking error isn't affected and overall performance is similar, if that is what the investor desires, as noted in the research of David Blitz and Frank Fabozzi.

And even if performance is affected, my behavioural efficient frontier, which takes into account the negative emotional and expressive benefits I would receive from investing in certain activities, may be lower than my purely financial mean-variance frontier, so I gladly accept the trade-off.

It may not make a difference to the market, but it makes a difference to me. For more on this point, see Meir Statman's book Finance for Normal People.

Bottom line: It's OK to use exclusions to avoid companies in which you would rather not invest - and it can make a difference.

Also keep in mind that while sustainable funds may use exclusions, their main thrust is applying ESG considerations in a systematic way throughout the investment process.

The outcome is a portfolio leaning toward sustainable high-quality companies--those that are addressing the sustainability issues they face in a way that adds to their long-term competitive advantage.